SAFE as SAFT?: Understanding Simple Agreements for Future Tokens
In the wake of a recent flurry of initial token offerings and the views taken by the US an Canadian securities authorities that tokens could be securities, developers, investors and lawyers have been searching for ways of ensuring compliant token offerings. In October 2017, the Protocol Labs and Cooley LLP (with the participation of other experts) announced the development of a compliant framework named a simple agreement for future tokens or “SAFT” designed to address the existing issues with the funding through the issuance of tokens.
The SAFT is a cousin of the SAFE, another contractual legal innovation that was developed in the Silicon Valley recently. Both the SAFE and the SAFT are similar in many respects, except that the SAFT entitles the instrument holders with the right to tokens rather than equity. This note provides a brief overview of the SAFE, SAFT and outlines some issues to be considered when planning to use the SAFT for capital raising activities.
What is SAFE?
SAFE stands for a Simple Agreement for Future Equity. Typically, under the SAFE, an investor obtains the right to a certain number of equity shares in the company in exchange for an up-front investment. The right is a right to convert investments into equity and is triggered upon occurrence of a specific event, such as acquisition, financing, etc. The conversion rate is usually based either on discount or valuation cap.
The SAFE was developed in response to the financing needs of a young and rapidly growing start-up company, and is designed to address the problems with convertible notes. The SAFE is almost identical to a convertible note, except that the SAFE does not have a maturity and does not contain interest provision. The absence of interest and maturity, arguably, distinguishes it from debt, however, the exact determination of whether a particular SAFE as debt depends on specific facts of a case, since the discount between the issuance price and the conversion rate could also be viewed as interest. The SAFE helps an entrepreneur get investments without spending too much time on drafting and negotiating complex deal terms. For investors, it allows to take part in a start-up while potentially retaining the upside of converting the SAFE instrument into equity.
However, the SAFE is not without cons. Because the SAFE does not have a maturity date, an investor might never realize her investment by converting the SAFE into equity. The SAFE does not provide any governance rights, and upon insolvency, the SAFE is likely to turn into an unsecured claim, which can be subordinated to unsecured debt and preferred equity. Since the typical SAFE does not have any restrictions on dividend payments, a start-up can declare dividends to its equity holders bypassing the SAFE holders, and a SAFE holder is unable to control such decisions.
For start-up entrepreneurs, the SAFE also has a number of issues. If the valuation cap is set too low or too high, the founder’s share in the company may end up being diluted upon conversion. The tax treatment of the SAFE is not entirely clear and the answer to this is likely to depend on particular circumstances. And because the SAFE is likely considered to be a security, a start-up cannot market and offer SAFE instruments other than in reliance on an exemption from the registration and prospectus requirements under securities laws.
In short, SAFE is an interesting innovation, however, it is not a “one size fits all” instrument and I am not sure if the SAFE would entirely replace convertible notes. The SAFE is likely to be relevant where an investor is given a chance to participate in a founding round of a rapidly growing start-up company that has the potential to be acquired at a later stage, and both parties are trying to avoid costly negotiations of deal terms.
Enter SAFT
The SAFT is a derivative of the SAFE and stands for the simple agreement for future tokens. Similar to the SAFE, under the SAFT, an investor, upon occurrence of a specific event (usually, it is launch of the network), becomes entitled to the right to a certain number of tokens equal to the purchase price divided or multiplied by the discount rate. The SAFT terms were developed with the collaborative participation of Protocol Labs, Cooley LLP, and numerous investors, lawyers and token holders (the SAFT Project), and are designed to offer standardized terms of compliant investments in tokens.
The idea for the SAFT is relevant to a specific class of “utility tokens” designed to be a medium of value to be used to purchase goods or services on a distributed network platform. The goods or services can be produced by the platform itself or network participants in the platform. For example, utility tokens can be used to purchase computing power in a distributed computing or storage in a distributed file storage platform.
The issue with utility tokens is that the majority of them tend to look like securities under US and Canadian securities laws, falling within a category of “investment contracts”. In Canada, Pacific Coast Coin Exchange v Ontario Securities Commission, [1978] 2 SCR 112 relying on SEC v WJ Howey Co, 328 US 293 (1946), laid out a test (the Howey Test) to determine whether a particular contract or a transaction in question is a security. The test is fact-specific and involves answering a question of whether a proposed transaction would be: (a) an investment of money (b) in a common enterprise © with the expectation of profit (d) to come significantly from the efforts of others. While the discussion of all elements of the Howey Test is outside of the scope of this paper, in many instances, tokens used in early-stage projects can pass parts (a) to © of the test, and it is part (d) “significant efforts of others” that might help to find out if a particular token could be an investment contract or not.
When a platform is not yet created, or is in the early stage being dependent on the efforts of its developers, tokens issued by such a platform would in most cases satisfy part (d) since it can be argued that the market price of such token depends on the significant efforts of others (aka management / developers). However, as the time goes, the platform becomes operational and more network participants subscribe to it and to the extent that the market price for such utility tokens is determined by forces affecting supply and demand, it is generally believed that such a factor would support the argument that the market price of the utility token of the platform is no longer dependent on the efforts of the management and therefore, would help to ensure that the fourth part of the Howey test (the “significant efforts of others”) does not apply. A prime example of such an automated decentralized platform could be Bitcoin.
The SAFT in this context would help to fund the efforts of the developers of the platform without resorting to token offerings, although such SAFTS are sometimes marketed along with the concurrent token offerings (which are often restricting investments from US/Canadian investors). The SAFT is a security, and can be sold pursuant to exemptions (i.e. “accredited investors”) available under the securities laws in the US and/or Canada. Upon successful launch of the platform (or some other event set out in the SAFT), the SAFT-holders would become token holders and should be able to trade tokens on a secondary market without restrictions because such tokens would cease to be “securities”.
The SAFT should help to overcome the shortcomings relating to the application of securities laws to “utility tokens” and could help to fund the development of a distributed network platform. However, there are a few finer points. First, the SAFT idea operates under an assumption that at some point a utility token would cease to be a security. This could be a long shot, because upon effective launch, a network platform could still be work in progress and would require support from the developers. As a result, a token in such platform could still pass the fourth part of the Howey test (“significant efforts of others”). Assuming that the first three parts in the Howey test are satisfied, such token would likely be viewed as a “security”. As a result, the SAFT holders, upon conversion, will still end up owning securities subject to resale restrictions that make them less liquid.
Second, while the SAFE looks like a convertible note, the SAFT is a different beast. If a utility token becomes a token to be used to purchase a product or service — the SAFT might look like a contract for the pre-purchase of goods or services (or a forward contract). As a result, if the token is viewed as a commodity, the SAFT could be considered as a commodity derivative. Finally, the status of the SAFT under tax law is unclear — it might be possible that tax authorities will treat the proceeds from the sale of the SAFT at the time of the sale rather at the time of the conversion thereby triggering income tax in the year the SAFTs were sold to investors (unless carried forward) rather than in the year when the conversion occurs.
Is it safe to use SAFT?
The SAFE itself is an innovative development relevant for investors willing to participate in a rapidly growing start-up. The SAFT is an adaptation of the SAFE it to the token world. It is almost identical to the SAFE, except that the SAFT may be converted into future tokens as products, whereas the SAFE is convertible into equity. However, the SAFT’s utility might reside in certain specific situations, but it is not a “one size-fits all”. Investors will need to consider the risks relating to the lack of liquidity, lack of governance rights and that they might end up with a security even after the platform launch. SAFT issuers will need to consider the risks of a SAFT being viewed as a commodity derivative and lack of clarity with respect to the classification of receipts resulting from the sale of SAFTs.
